NEW YORK (Reuters) -With the U.S. government shutdown threatening to freeze October's inflation report, the Treasury is expected to deploy a workaround to compute the index underpinning the $2.1 trillion market for inflation-protected bonds for the first time since their 1997 launch, a move that may cause pricing quirks as traders adjust their calculations.

The Bureau of Labor Statistics has said it has halted all data collection and publishing during the shutdown, apart from recalling staff to deliver September's Consumer Price Index, released last Friday. With the standoff now the second-longest on record, the White House warned there will likely be no inflation data published next month, which means the BLS' October CPI report scheduled for November 13 won't be released. 

That could be a headache for Treasury Inflation-Protected Securities (TIPS) market participants, as the value of those bonds, which investors use to protect their capital from inflation, hinges directly on the index. TIPS pay a fixed interest rate, but the interest is calculated on a principal amount that rises with inflation and falls in periods of deflation. How much the principal rises or falls is determined by the CPI index.  

TIPS yields, also known as "real yields" because they discount inflation, have increased slightly over the past few days, which some market participants said may reflect uncertainty over their pricing in the absence of CPI data. Yields rise when bond prices fall.

"There's definitely uncertainty in the market around the data itself, which is then exacerbated by the lack of data. So you end up with high risk premium in TIPS and they end up trading cheap," said Benjamin Wiltshire, global inflation desk strategist at Citi.

The Department of the Treasury has a workaround plan in case CPI for a particular month is not reported by the last day of the following month, which consists in producing a fallback index based on the last available 12-month change in the CPI, according to Treasury regulations.

Should the October CPI not be released by the end of November, Treasury would be forced to produce the fallback index for the first time since TIPS were launched, market participants said.

Asked to comment on this story, a spokesperson at the Treasury referred Reuters to index contingencies related to TIPS that are addressed in the Treasury's Uniform Offering Circular, which details the mechanism that would be used to produce a fallback index.  

Yields on 10-year TIPS were at around 1.7% on Wednesday, not much changed since late last week. Five-year yields were last at 1.249%, slightly higher. 

Still, investors and analysts said any potential pricing distortion going forward would have a limited impact on demand for the paper.

"We don't think the use of a fallback index will impact investor demand for TIPS going forward," said Phoebe White, head of U.S. inflation strategy at J.P. Morgan. "Most regular investors in the product are aware of the technicality, and others who only trade the product infrequently usually look at TIPS with a longer-term outlook in mind," she added.

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Experts pointed out that investor sentiment for TIPS heading into the next auction will be dictated by how long the U.S. government shutdown drags on. Moreover, the lack of availability of official data is affecting the broader perception of the actual state of the economy, said Matt Hornbach, global head of macro strategy at Morgan Stanley.

The next TIPS auction, for 10-year paper, is scheduled for November 20. 

"If the general environment persists through that period of time, then it would be normal to see investors continue to shun the product," Hornbach said. "If we can come out of the shutdown well ahead of that next auction, we can get a better handle on what's happening in the real economy from an inflation and growth perspective, and then that may bring investors back into the fold, but it really depends on when the government reopens." 

For the time being, lower market expectations of rising price pressures may have a more meaningful impact on TIPS demand than the uncertainty over the lack of CPI data, some market participants said.

U.S. consumer prices increased slightly less than expected in September, CPI data showed last week.

"Clearly inflation, relatively speaking, as much as it's high, it's surprising to the lower downside," said John Madziyire, head of U.S. Treasuries and TIPS at Vanguard.  

"With the workaround at least you have positive CPI so you're getting something," he said. "It is not obviously going to be perfect, but then again, all of these data points are not perfect."

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